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The Saudis are determined

Saudi Arabia is focused on reducing surplus oil inventories, and the extension of production cuts along with growing global demand is helping.

WTI crude is $61 per barrel, with a $4 per barrel discount to Brent (as of March 15). WTI increased 36% from $49 in 4Q 2016 when the Organization of the Petroleum Exporting Countries (OPEC) announced its agreement with Russia and other non-OPEC producers to cut production to the late January peak near $67. It averaged $51 in 2017 and $43 in 2016. The Brent premium blew out to more than $7 in December and has contracted since. Brent averaged $3.10 higher than WTI in 2017 and $2.45 higher in 2016 (see “Crude spread,” below).

How we got here

The run-up in crude to the January peak mirrored the decline in surplus the Organization of Economic Cooperation and Development (OECD) inventories had targeted by the OPEC cut. The OECD surplus to the five-year average declined 84% from 318 million barrels (MMB) in early 2017 when the cut was implemented to 50 MMB in January by OPEC’s estimate. The International Energy Administration (IEA) calculated a surplus of 53 MMB, down from 264 MMB a year ago. The OECD accounts for 48% of total world oil demand.

OPEC is pleased with its performance and the result. Compliance during the period has been high. February production was 32.10 million barrels per day (MMBD) compared to an average of 32.34 MMBD in 2017. It is 1.3 MMBD less than 33.40 MMBD produced in Q4 2016 when the cut was announced.

OPEC’s June meeting will be a checkpoint

Saudi Arabia recently said it “Hopes OPEC and its allies (primarily Russia) will be able to relax production cuts next year and create a permanent framework to stabilize oil markets after the current agreement on supply cuts ends.” It also said it hopes to announce a new target at OPEC’s next full meeting on June 22 in Vienna. OPEC and Russia account for 45% of world crude supply. The OPEC meeting will provide a very important checkpoint for U.S. producers and the market in general. Oil traders may choose to be cautious until the meeting.

The Saudis plan to cut March and April production by 100 (thousand barrels per day) MBD from 9.98 MMBD in February and keep exports below seven MMBD as it “remains focused on working down excess oil inventories.” It may continue to cut in May.

Higher oil prices would benefit its historic initial public offering of Saudi Aramco shares expected sometime in 2019. It requires $70 Brent crude oil prices to balance its state budget in 2018.

Where the road is pointing

In the run-up to the June OPEC meeting, oil prices are likely to remain relatively stable the next few months because the seasonal increase in inventories will be quite small.

For OPEC, the outlook for the second half of 2018 is both promising and challenging. Demand growth is very strong. It is projected to increase in the second half of this year by 1.4 MMBD from 99.0 MMBD in Q2 2018 to 100.4 MMBD in Q4 2018.

Non-OPEC production growth is also very strong. U.S. liquids production is projected to increase 935 MBD during the same period. Other non-OPEC supply adds 700 MBD, primarily from Brazil, Canada, and Kazakhstan, where the ssupergiantKashagan Field is expected to reach 370 MBD from 250 MBD at the end of 2017.

Inventories are likely to remain relatively balanced the rest of the year stabilizing oil prices near current levels. However, downside oil price risk may emerge in Q4 2018 from a potential acceleration in the growth of Permian production.

For the year, the IEA estimates world oil demand will average 99.3 MMBD, up 1.5 MMBD from 2017; following an increase of 1.57 MMBD in 2017 and 1.22 MMBD in 2016 (see “Demand growth”). China, India and Africa lead demand growth. Global economic growth is strong. Since 2015, global oil demand has grown about five MMBD, twice as fast as the previous three years.

For the year, U.S. oil and liquids production will average 15.01 MMBD, up 1.96 MMBD year-over-year, following an increase of 702 MBD in 2017 and a decline of 348 MBD in 2016. In Q4 2018, it may reach 15.78 MMBD, a level, which may put downward pressure on oil prices.

Permian oil production is likely to increase well over 30% this year, about 930 MBD, to average 3.35 MMBD, with a December exit rate of 3.85 MMBD based on an anticipated flattening of the Permian rig count around 450 in May or June. The current Permian rig count is 436, up from 398 in December. The production estimate is supported by guidance provided by the 10 largest producers in the basin. They accounted for 35% of Permian oil production in 2017.

All other U.S. oil production will increase about 490 MBD in 2018, while gas liquids increase 540 MBD. Higher oil prices this year are stimulating increased drilling activity.

The Permian Basin is the main growth driver in the second half of 2018. The cost per well continued to decline in 2017. New wells are producing double or more the initial rate that for years was the standard for a good unconventional well, significantly improving return on investment for producers and reducing the oil price needed to break even after offsetting the cost of oilfield services inflation. The new U.S. tax law will reduce breakevens in U.S. resource plays by $2 per barrel and $4 per barrel on average in the Gulf of Mexico. Permian oil production will account for 31% of U.S. oil production in 2018.

In 2018, other non-OPEC production will average 45.22 MMBD, up 227 MBD from 2017, following a 32 MBD decline in 2017 and a 433 MBD decline in 2016.